With so many dividend shares trading at cheap valuations this year, passive income opportunities seem to be everywhere. As such, a patient investor could generate a sizable nest egg in the coming years.
Buying a diversified collection of dividend stocks today could open the door to sustainable returns. And in the long run, earning £1,000 a month without having to lift a finger could become a reality.
Using cheap dividend shares to build a passive income
With the ongoing stock market correction sending dividend shares in the wrong direction, a lot of wealth seems to be evaporating. However, the economic disruptions behind this decline are ultimately short-term issues. For example, a big concern right now is high inflation. And as of July, it’s already started to decline here in the UK.
As the economy steadily gets back on track, stocks are likely to follow. Suggesting that time could be running out to snatch up some cheap dividend shares. But that doesn’t mean I should buy all the highest-yielding stocks I can find.
A high yield is often a sign of unsustainability, typically leading to a dividend cut in the near future. Inflation may be a temporary problem, but its impact on businesses today is very real. Many companies are still struggling to recover from the pandemic, especially those that had to load up on debt during lockdowns.
In other words, a high yield today has little value if the underlying firm doesn’t have enough cash flow to service its loan obligations, let alone its shareholder dividends.
That’s why I’m only interested in passive income stocks with resilient balance sheets, uncompromised cash flows, and prudent leadership. These not only have the capability of providing reliable and growing dividends but also offer share price growth potential as their stocks steadily recover.
Making £1,000 a month without working
The short-term outlook of the stock market remains unpredictable. Consequently, a new portfolio of dividend shares today could experience declines in the coming weeks and months.
However, in the long term, provided I haven’t selected bad businesses, these dividend stocks are likely to eventually recover, offering a tasty dividend in the meantime. So if I want to generate £1,000 a month in passive income, what do I actually need?
The average dividend yield of the FTSE 100 has historically sat at around 4%. By picking individual dividend stocks rather than investing in an index fund, I could reasonably build a portfolio yielding 5%. But therein lies the rub. At a 5% yield, I’ll need a portfolio worth £240,000 to generate a £1,000 monthly passive income.
That’s not exactly pocket change. Yet reaching this figure isn’t as impossible as many think. Here in the UK, the stock market has historically delivered an average 8% annualised return. At this rate, if I invest £500 each month, then in 20 years, my portfolio would theoretically reach £240,000.
In practice, the process may take a bit longer. As many have discovered, the stock market does occasionally decide to have a tantrum. And depending on when this happens again in the future, it could prolong the wealth-building process.
But given the potential long-term reward, this is a risk worth taking, in my opinion.